Mark-to-market accounting and systemic risk: evidence from the insurance industry

Andrew Ellul, Chotibhak Jotikasthira, Christian T. Lundblad and Yihui Wang

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: One of the most contentious issues raised during the recent crisis has been the potentially exacerbating role played by mark-to-market accounting. Many have proposed the use of historical cost accounting, promoting its ability to avoid the amplification of systemic risk. We caution against focusing on the accounting rule in isolation, and instead emphasize the interaction between accounting and the regulatory framework. First, historical cost accounting, through incentives that arise via interactions with complex capital adequacy regulation, does generate market distortions of its own. Second, while mark-to-market accounting may indeed generate fire sales during a crisis, forward-looking institutions that rationally internalize the probability of fire sales are incentivized to adopt a more prudent investment strategy during normal times which leads to a safer portfolio entering the crisis. Using detailed, position- and transaction-level data from the U.S. insurance industry, we show that (a) market prices do serve as ‘early warning signals’, (b) insurers that employed historical cost accounting engaged in greater degrees of regulatory arbitrage before the crisis and limited loss recognition during the crisis, and (c) insurers facing mark-to-market accounting tend to be more prudent in their portfolio allocations. Our identification relies on the sharp difference in statutory accounting rules between life and P&C companies as well as the heterogeneity in implementation of these rules within each insurance type across U.S. states. Rather than promoting a shift away from market-based information, our results indicate that regulatory simplicity may be preferred to the complexity of risk-weighted capital ratios that gives rise, through interactions with accounting rules, to distorted risk-taking incentives and potential build-up of systemic risk.

Keywords: Regulation; Systemic risk; Mark to market; Historical cost accounting; Fire sales; Capital ratios; Insurance companies (search for similar items in EconPapers)
JEL-codes: G11 G12 G14 G18 G22 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2013-10-22
New Economics Papers: this item is included in nep-acc, nep-ias and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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